How will the Fed react to the GDP report?

By Mark Thoma

July 27, 2012 / 3:49 PM
/ MoneyWatch

(MoneyWatch) GDP grew at 1.5 percent in the second quarter of this year according to the
advance report from the BEA. The increase in GDP, while positive, represents
a slowdown from first quarter growth, driven primarily by a fall
in consumption growth, a fall in the growth of business
and housing investment, an increase in imports, and declines in government spending, particularly at the
state and local level. [For more details, see my colleague Jack Otter's analysis] Overall the report paints a
picture of an economy that is stagnating instead of recovering robustly.
With GDP growing too slowly to provide jobs for the millions of unemployed
still seeking work, and too slowly to even keep up with population growth -- a 2.5
to 3 percent growth rate is needed to absorb new entrants into the workforce,
and even higher rates are needed to make inroads on the unemployment problem --
the question turns to potential policy reactions. How will monetary and fiscal
policymakers react to the news of slowing GDP growth?

Political gridlock in Congress makes a fiscal policy response very unlikely,
so there is little hope of an aggressive job creation program, an increase in
infrastructure spending, or any other fiscal stimulus. Thus, the real question
is whether this report will spur the Federal Reserve to do more
to help the economy.

It will be difficult for the Fed to avoid doing more. The Fed is clearly not fulfilling its mandate to support maximum employment, and today's report leaves little hope that will
change without further policy action. In addition, the Fed is falling short of
its inflation target of 2 percent. The price index the
Fed watches most closely, the Personal Consumption Expenditures index, was up
1.6 percent year over year, while the same index excluding food and energy -- a
key for Fed policy -- was up 1.8 percent from a year ago. Other inflation
measures are also running below the Fed's 2 percent target, and like the
unemployment numbers, this calls for more aggressive policy.

With the Fed currently missing both parts of its mandate, the main question
is not whether the Fed will take action -- in all likelihood it will -- but when it
will act and what it will do. The when part is likely to be answered next week
when the FOMC meets, and I expect the Fed will ease further at that time. What,
exactly, it will decide to do to try to help for the economy is a more
difficult question.

Despite the fact that a temporary increase in the inflation rate would stimulate the economy, the Fed remains worried about the potential for a long-term inflation problem
and is thus wary about expanding its balance sheet through another round of
quantitative easing. But actions that carry little inflation risk, such as operation twist, do not have much power to stimulate the economy. And with
inflation running below target, despite the warnings of inflation hawks for
several years now that inflation is just around the corner, and with output
and employment stagnating, I expect the doves will prevail and that some form of modest
quantitative easing is likely. It won't be as aggressive as many would like -- hence the qualifier "modest" -- but it's hard to imagine the Fed continuing to sit on its hands when all signs are pointing in the same direction.

View all articles by Mark Thoma on CBS MoneyWatch»
Mark Thoma is a macroeconomist and time-series econometrician at the University of Oregon. His research focuses on how monetary policy affects the economy, and he has worked on political business cycle models. Mark is currently a fellow at The Century Foundation, and he blogs daily at Economist's View.